A bond is a written unconditional promise to pay a specific principal sum at a determined future date, and interest at a fixed or determinable rate on fixed dates. Bonds are issued by governments to finance their budget, but also by other entities having a high credibility such as banks and large companies. Thus, a bond is a debt instrument meaning that it is a loan payable to the holder of the bond for some fixed amount known as the bond's face value. Attached to the bond is a so-called coupon. Named for its historical similarity to actual coupons you would clip for grocery shopping, the coupon is usually a fixed interest payment made to the bondholders semi-annually or some other periodicity.
Bonds can also be bought and sold on the secondary market at current market prices; in that case you get interest for as long as you own the bond. Bonds are conventionally traded either manually, e.g. over the phone or using an automated matching system.
In addition to conventional bonds, there also exists a market for so-called stripped bonds. A stripped bond is a bond that can be subdivided into a series of zero-coupon bonds. The only difference between a strip bond and a regular bond is that some financial institution removes the coupon payments and sells both the face value and the coupon payments separately. Thus, rather than receiving the face value of the bond plus coupons, a bondholder of a stripped bond will only receive the par value. The profit investors make from purchasing stripped bonds surface through the spread between the discounted purchase price and the maturing value.
When a Treasury fixed-principal or inflation-indexed note or bond is stripped, each interest payment and the principal payment becomes a separate zero-coupon security. Each component has its own identifying number and can be held or traded separately. For example, a Treasury note with 10 years remaining to maturity consists of a single principal payment at maturity and 20 coupon payments, one every six months for 10 years. When this note is converted to a stripped form, each of the 20 coupon payments and the principal payment becomes a separate security.
The Treasury does not normally issue or sell stripped bonds directly to investors. Thus, stripped bonds can normally be purchased and held only through financial institutions and government securities brokers and dealers.
Stripped bonds are traded with increased popularity among investors who want to receive a known payment at a specific future date. For example, some State lotteries invest the present value of large lottery prizes in stripped bonds to be sure that funds are available when needed to meet annual payment obligations that result from the prizes. Pension funds invest in stripped bonds to match the payment flows of their assets with those of their liabilities to make benefit payments. Stripped bonds are also popular investments for individual retirement accounts.
In the process of stripping a bond, a financial institution, government securities broker, or government securities dealer can convert an eligible Treasury security into interest and principal components through the commercial book-entry system. Generally, an eligible security can be stripped at any time from its issue date until its call or maturity date.
However, at present, the bond market and stripped bond market are two separate markets although the traders trading in the two markets are in general the same people. As a result, liquidity on the two markets suffers.
Also, since the same traders trade both in the conventional bond market and in the stripped bond market, those traders need to cover two markets simultaneously, which is difficult and is also associated with an additional risk.